First-time entrepreneurs who're out to raise their first or even subsequent rounds of funding don't always realise that they can (and should) do DD on their prospective investors, not just the other way around. Why don't they realise this?
The most obvious reason is the skewed balance of power. The entrepreneur wants money and the investor holds the purse strings. But is this really a skewed balance of power? It really depends on who the specific parties are. A strong entrepreneur who has a good investment opportunity to offer and several interested investors can certainly shift the balance back in his favour. (This has been most obvious in Silicon Valley in the recent past, where super-star entrepreneurs raise money at valuations unheard of in Asia.)
Another somewhat related reason for entrepreneurs' diffidence is the unwritten but widespread belief that investors are omniscient super-beings who are above question. That's one big reason why MBA grads, senior guys in operating roles, and even investment bankers clamour to move to investing roles. Nonsense. Just as there are good and crappy entrepreneurs, engineers, journalists and marketing professionals, there are good and crappy investors too.
Ok, so you're convinced. You know the value of doing your homework on your investors. What questions should you be thinking about?
- Ask the investor straight out: what is your vision for my company? There is no right answer to this question, but the answer will tell you a lot about how this investor thinks, what her aspirations are for making this investment, whether she prefers to let you run the show on your own or sees herself getting involved, and so on. Whatever the answer may be, you will get some insight into how you will engage with each other in future. You can then decide whether there is congruence with your own expectations.
- Do I enjoy engaging with the investor? Does this person provide supportive feedback that also challenges me? Does this person complement the skills I already have available within my company and board of direectors?
- Who is doing the work of evaluating my company? Has the work been delegated to a junior employee? Or even an external consultant?
- Who is the actual person going to be involved with my company after the investment?
- Is the investor an employee of her firm or a partner with some influence and stake in her firm's success? This is less about the person's title than the responsibility given to her and her willingness and ability to assume these responsibilities.
- What do others say about this investor? This is a broad question that can cover several areas such as personality, influence, level of involvement with portfolio companies, and so on. You have to be careful what you find out as your sample size of responses is likely to be small. Treat this as one input among many.
- Does this firm have an eat-what-you-kill philosophy with individual investment partners responsible for their own successful or failed investments? Or are you likely to be working with more than one investment partner equally incentivised to make your company successful?
- What are this firm's ongoing reporting requirements? Do you need to hire a finance person just to create investor reports?
- Does this firm have a track record of making follow-on investments? If it does, do follow-ons typically happen in successful companies or in troubled ones?
The one question you don't see above is whether this investor has experience making investments in your specific sector. This is partly because, at least in the tech world, industry cycles move very quickly, and a five-year old investment may have little relevance to you today. More important, what matters more from your perspective is whether the investor has done her homework on your industry, has overseen investments in at least a few start-ups before yours and has evaluated at least several hundred firms in total. You're the expert in your industry sector, not your investor. The investor only (only!) needs to be good at helping you with the overall company-building process and everything that entails.